Facebook's Façade: Why We Unfriended This Stock Even Before All The Trouble Started

Posted: Apr 10, 2018 1:55 PM
Facebook's Façade: Why We Unfriended This Stock Even Before All The Trouble Started

Facebook has been flooded with dislikes over the past few weeks from the press and from investors. As a general rule, negative headlines produce negative returns. But the problem with using that as an investment tool is that pretty much everyone can see the headlines at the same time. So the trick is to not own a company BEFORE the bad stuff hits the presses. In the lingua Facebook parlance, the key is to be one of the earlier dislikes, rather than one of the later ones.

How do you do this? You do it by looking at three major categories of analysis.

One, does it look like the company might have 'fake news' in its financial statements? Balance sheets and Income Statements and (to a lesser degree) Statements of Cash Flow are supposed to report what has actually gone on in the financial performance of a company. They are supposed to report the financial news straight. Often, however, they tell it slanted in a way which (they think) benefits the company. This tends to be a matter of making things look good in the short run. Almost all of the ways of distorting earnings reporting (and most of them are perfectly legal) involve timing issues - showing revenues early or showing expenses late. It’s an important distortion to track, if you can, because eventually the truth comes out. This sort of thing is also important because it’s a glimpse into the corporate culture. Managers who don't tell the straight truth to their owners, come what may, tend to be managers that don't put owners' interests ahead of top management.

Facebook showed warning signs in regard to financial reporting. Their reported data is not a huge red flag--it's basically worse than average but not egregious—but there are two areas that stick out as problematic. First, there is a lot of room for shenanigans when it comes to accruing revenues early and deferring expenses into the future. Technology companies like Facebook, by their nature, have a lot of intellectual capital and a lot of good will and other assets which are not hard assets. Valuing things like property, plant and equipment is relatively easy compared to valuing the types of abstract assets that media/tech companies tend to have on the books. So, these warning signs could indicate a problem or they could just be par for course when it comes to valuation in the strange new world of social media. It's hard to tell, and when you're assessing risk, 'hard to tell' means be wary, not complacent.

Second, things would be different if Facebook were 'on sale', but this is a company which at the end of January, when we last looked at this, was anything but 'on sale'. It was at very high valuations; so high in fact, that many analysts stopped talking about old school metrics like PE ratios and switched over to items like sales growth. Sales growth is a nice thing, but it's not a valuation metric. By normal valuation metrics, Facebook was priced for growth AND safety. Whatever measure of prices of investment in comparison with whatever various components of income one looked at, this was a company which was not offering income at a bargain price.

Third, Facebook's structure is designed to keep shareholders unfriended. The relationships as they should be are: shareholders at the top, board under shareholders and management under board. Facebook doesn't work that way. It places enormous power in the hands of the CEO/Chairman. We'll detail that out more in the future in this space, but companies (like governments) need rules which keep bureaucracies subordinate to interests of the 'owners'.

These are the reasons that the portfolios I work on which invest in US equities did not hold Facebook stock.